The profitability index is known as benefit cost ratio. PI is similar to the NPV approach. The profitability index approach measures the present value of return per dollar invested, while the NPV is based on the difference between the present value of the future cash inflow and present value of cash outlay. PI is calculated by dividing the present value of future cash inflow by present value of cash outlay.
Profitability Index (PI) = Total present value/Net cash outlay
It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay
Decision Rules of Profitability Index (PI)
- If projects are independent
Accept the project when PI is higher than 1.
Reject the project when PI is less than 1.
2. If projects are mutually exclusive
Accept the project which has higher PI.(PI must be greater than one)
Reject other project.
In above calculation, project B should be selected because it has higher PI.
Advantages Of Profitability Index (PI)
- PI considers the time value of money.
- PI considers analysis all cash flows of entire life.
- PI makes the right in the case of different amount of cash outlay of different project.
- PI ascertains the exact rate of return of the project.
Disadvantages Of Profitability Index(PI)
- It is difficult to understand interest rate or discount rate.
- It is difficult to calculate profitability index if two projects having different useful life.